The Federal Reserve Board has issued proposed amendments to Regulation Z that would expand the scope of the existing ability-to-repay requirement, establish new minimum underwriting standards, and impose new limits on prepayment penalties for residential mortgage loans. The proposal is intended to implement amendments to the Truth in Lending Act (TILA) made by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Comments on the proposal must be filed by July 22, 2011. Because TILA rulemaking authority transfers from the Fed to the Consumer Financial Protection Bureau on July 21, 2011, all comments will be forwarded to the CFPB, which will finalize the proposal. Some highlights of the proposal appear below.

Repayment Ability. The proposal would impose an ability-to-repay requirement on a “covered loan,” which is a consumer credit transaction secured by a dwelling, other than a home equity line of credit, timeshare plan, reverse mortgage, or bridge loan with a term of 12 months or less. Currently under Reg. Z, such a requirement applies only to “higher-priced” mortgage loans.

A creditor would be prohibited from making a covered loan unless it makes “a reasonable and good faith determination at or before consummation that the consumer will have a reasonable ability, at the time of consummation, to repay the loan according to its terms, including any mortgage-related obligations.” A creditor would have to consider and verify certain specific underwriting factors, including the consumer’s (1) employment status if the creditor is relying on employment income to determine repayment ability, (2) credit history, (3) monthly payment on the covered loan, (4) monthly payment “on any simultaneous loan that the creditor knows or has reason to know will be made,” (5) monthly payment for mortgage-related obligations, and (6) current debt obligations. Although the Dodd-Frank Act did not require consideration of home equity lines of credit (HELOCs), the proposal would include HELOCs in the definition of “simultaneous loan.”

For purposes of calculating the monthly payment on a covered loan, the creditor must use (1) the greater of the fully indexed rate or any introductory rate, and (2) monthly, substantially equal payments that amortize the loan amount over the loan term. Special payment calculation rules would apply to loans with a balloon payment, interest-only loans, and negative amortization loans. A refinancing by the same creditor of a “non-standard mortgage” would generally be exempt from the ability-to-repay requirement if the new loan were a “standard mortgage,” the consumer’s monthly payment would be reduced, and the consumer were current on the existing mortgage.

A “non-standard mortgage” is an adjustable-rate mortgage with an introductory fixed rate for the first year or longer, an interest-only loan, or a negative amortization loan. A “standard mortgage” is a loan that does not (1) have a term longer than 40 years; (2) provide for regular periodic payments that result in negative amortization, deferral of principal repayment, or a balloon payment; (3) have “points and fees” greater than those permitted for “qualified mortgages” discussed below; (4) have an interest rate that is not fixed for at least the first five years; or (5) provide the consumer with any funds for discretionary spending (i.e., it must be a “no-cash-out” refinance).

Qualified Mortgages. The Dodd-Frank Act provides that a creditor or assignee “may presume” that a loan that is a “qualified mortgage” meets the repayment ability requirement. A “qualified mortgage” must satisfy certain criteria listed in the statute, including that it may not (1) have a term longer than 30 years; (2) provide for regular periodic payments that result in negative amortization or, subject to certain exceptions, deferral of principal repayment or a balloon payment; or (3) have “points and fees” that exceed a prescribed limit.

To address statutory ambiguity as to whether a “qualified mortgage” provides a safe harbor or a rebuttable presumption of compliance with the repayment ability requirement, the proposal contains two alternative definitions. One definition contains only the statutory requirements for a “qualified mortgage” and would provide creditors with a safe harbor if those requirements were met. The other definition includes additional requirements taken from the repayment ability requirements, such as the consumer’s employment status and monthly payment on any simultaneous loan, and would provide a rebuttable presumption of compliance.

The “points and fees” that may be charged on a “qualified loan” were limited by the Dodd-Frank Act to 3 percent of the loan amount, with the Fed authorized to adjust that limit for smaller loans. The proposal contains two alternatives for implementing the “points and fees” limit for loans less than $75,000. Each uses a “tiered approach” in which the allowable percentage of the total loan amount to be charged in points and fees would vary based on the loan amount.

Violations of the repayment ability requirements are subject to enhanced Home Ownership and Equity Protection Act (HOEPA) statutory damages, equal to the sum of all finance charges and fees paid, unless the creditor demonstrates that the failure to comply was not material. This recovery is in addition to actual damages and the regular statutory damages available under TILA.

The definition of “qualified mortgage” also has implications beyond TILA. The Dodd-Frank Act provided that, for purposes of the rules implementing the statute’s risk-retention requirements, the definition of a “qualified residential mortgage” can be “no broader” than the TILA definition of a “qualified mortgage.” Those requirements include an exemption for asset-backed securities collateralized exclusively by “qualified residential mortgages.” In their proposal of the “skin-in-the-game” rules, the Fed and other federal agencies indicated that they would monitor the Reg. Z rule to determine whether it would require changes to their proposed definition of a “qualified residential mortgage.” (Click here to read an earlier legal alert on the “skin-in-the game” rules.)

Prepayment Penalty Limits. The proposal would allow a prepayment penalty only in a “covered transaction” that (1) has an APR that cannot increase after consummation, (2) is a “qualified mortgage,” and (3) is not a higher-priced mortgage loan. The penalty must decline from a maximum of 3 percent of the outstanding balance in the first year to no more than 2 and 1 percent of such balance in years two and three, respectively, and no prepayment penalty would be permitted after the third year. Creditors offering a consumer a mortgage loan with a prepayment penalty would also have to offer that consumer a mortgage loan without a prepayment penalty that satisfies certain conditions. The proposal would not implement the new requirements for high-cost mortgages in the Dodd-Frank Act, which include a prohibition on prepayment penalties in such loans.

Violations of the prepayment penalty limits are subject to actual damages and regular TILA statutory damages.

Expanded Record Retention. Because the Dodd-Frank Act extended the statute of limitations for civil liability for a violation of the ability to repay requirements and prepayment penalty limits to three years, the proposal would extend the Reg. Z document-retention requirement from two to three years for documents that evidence compliance with those specific requirements and limits.

Ballard Spahr’s Consumer Financial Services Group is nationally recognized for its guidance in structuring and documenting new consumer financial services products, its experience with the full range of federal and state consumer credit laws throughout the country, and its skill in litigation defense and avoidance (including pioneering work in pre-dispute arbitration programs). For more information, please contact Group Chair Alan S. Kaplinsky, 215.864.8544 or; Vice Chair Jeremy T. Rosenblum, 215.864.8505 or; John L. Culhane, Jr., 215.864.8535 or; Keith R. Fisher, 202.661.2284 or; Barbara S. Mishkin, 215.864.8528 or; or Mark J. Furletti, 215.864.8138 or


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